Question

Problem 1 Suppose that two factors have been identified for the U.S. economy: the market return (MKT) and the interest rate (IR). MKT is expected to be 7%, and IR 3%. The risk-free rate is 2%. a. [1pt] What are the risk premia of market and interest rate factors? b. [1pt] What is expected return of a stock with a beta of 1.2 on MKT and 0.3 on IR? c. [2pts] If market return actually increases 1%, while the interest rate turns out to be 4%, does the expected rate of return on the stock increase or decrease and by how much?

Answer 1

a) Calculation of risk premia:

Risk premia of market= market return-risk free rate= 7-2=5%

Risk premia of IR= 3-2= 1%

b) calculation of expected return:

Expected return of MKT= risk free rate+beta*risk premia

Expected return= 2+1.2*5= 8%

Expected return of IR= 2+0.3*1= 2.3%

c) calculation of expected return of market when return is 8%

Expected return= risk free rate+beta*(market return-risk free rate)= 2+1.2*(8-2)= 9.2%

Calculation of expected return when return of IR is 4%

Expected return= 2+0.3*(4-2)= 2.6%

With increase in the market return and interest return, the expected return will increase because with increase in market return expected return increase